What’s happened to the cycle?

Conventional market wisdom dictates that a slowdown normally becomes a recession, and that investors should sell equities ahead of a downturn. Additionally, higher rates should eventually lead to lower inflation, at which point investors typically favour bonds. These phenomena tend to overlap more as the threat of a recession grows. 

But the events of 2022 and 2023 seem to be testing this understanding. In this weekly instalment of Simply put, we investigate key dynamics of this unconventional cycle.

 

Need to know: The current cycle shows some idiosyncrasies – such as the fact that higher rates are not triggering a profound slowdown Short rates are probably not high enough to induce a downturn, meaning that funding conditions have not yet been able to trigger a decline in growth US consumers are still in a decent situation, delaying the impact of the higher rates on risky assets and supporting their elevated valuations

 

A weird cycle

Growth in the US is not only stronger than expected but is also showing an actual (and very) early recovery. This is despite the absence of an earnings recession – a fact that has probably contributed to equities performance year-to-date. 

This leads to interesting questions: is the cycle dead? Shall we remain overweight equities permanently, since sticking to this exposure helped so many investors weather the 2020 storm? 

To address them, we should at least acknowledge the peculiarities of the current period – from the positions taken by central banks, to the current macro drivers of risk assets. This is a weird cycle, and it isn’t over.
 

What is specific to this tightening cycle?

To understand what is currently happening, and especially in the US economy, it is essential to understand how the Federal Reserve (Fed) intends to reach its target of a ‘soft landing’ – a technical or shallow recession that would sufficiently eliminate inflationary pressures. Figure 1 compares the current cycle to the eight preceding ones. Two different kinds of figures are presented here:

1. Panel A shows the difference between the highest level reached by short-term rates and the highest inflation reading. Since Paul Volcker was chairman of the Federal Reserve, from 1979 to 1987, the common practice has been to raise rates higher than the level of inflation itself. In recent years, rates have usually risen until the difference shown on the chart was brought close to zero, given the Fed’s additional focus on not plunging economies into deep recession. 
   
   The cycle that started in 2022 was clearly at odds with this approach, as the current gap is the largest and only negative one in the past 50 years. This is done to avoid bending the economy downward until it breaks. So far, apart from a 12-day banking crisis, it’s worked.
    
2. Panel B shows another way in which the 2022 tightening cycle stood out: the pace of hikes 2022. Apart from the 1972-1974 hiking period, we have never seen rates lifted so fast, with an average 0.4% per month. This contrasts with the unusually low terminal rate in the face of such a large surge in inflation. By hiking rates so rapidly, has the Fed damaged the economy? 

Investors therefore need to decide which of these two elements should drive the cycle now: the speed of the hikes or the unusually low levels of (realised) real rates. Should the first take the lead, the tighter financing conditions should create a slowdown and eventually a recession. Should the second take the lead, consumption should continue rising as rates are not high enough to weigh on the economy. Markets would respond positively, given their focus on nominal growth.
 
Which of these two should we look at? Conventional wisdom says the first, but markets are forcing us to look in both directions at the same time, which is an unpleasant feeling for all investors.
 

FIG 1. Defining figures: the past 50 years of tightening cycles

Panel A

Panel B

Source: Bloomberg, LOIM as at August 2023.

 

What are markets looking at?

The equities rally from June to August and concurrent tightening of credit spreads is the perfect example of the complex equations being worked out amid tighter funding conditions and the somewhat decent situation for the US consumer. Regressing the S&P 500 returns on daily trackers for consumption growth and financial conditions (both of these being part of our growth nowcasting indicator) yields figure 2.  

The chart shows the explanatory power of each factor. Macro factors are not known to be primary considerations for markets, but since July both factors have gained in importance. Consumption has remained the number one driving factor in terms of relative importance. Even if the first few weeks of August seem to have been less driven by the macro picture, consumption remains dominant in the realm of macro factors.
 
Quite legitimately, the recent improvement in the US macro newsflow challenges us in that respect. Conventional wisdom here says funding conditions should be the most important element but the events of 2023 quite clearly dispute that. We think that it probably remains too early to take the message of recent months as a given: with rates as high as they are, it remains difficult to move away from our medium-term disinflationary scenario just now. But the recent improvement in consumption data says the road there could be bumpier than expected.
 

FIG 2. Explanatory power of daily consumption and financial conditions data over S&P 500 returns

Source: Bloomberg, LOIM as at August 2023.       
 

 

Simply put, financing conditions are tighter but consumption growth remains solid, reflecting the Fed’s unconventional strategy. The disinflation case remains in place but the road leading there could be rough.

 

 

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Nowcasting corner

This section gathers the most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary-policy surprises. These indicators keep track of the most recent macro evolutions that make markets tick.

Our nowcasting indicators currently point to:

• Our growth indicator in the US continued its recent progression, lifting our world-growth indicator. We are currently capturing a recovery, absent a genuine recession
• US inflation exceptionalism continues, with 77% of data rising over a one-month period
• Our monetary policy indicator continues to point towards an unsurprising monetary situation 

 

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Source: LOIM as at August 2023. Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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